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Monday, August 31, 2009

Earnings Capacity: An Example

Last week, we discussed a method for estimating a company's earnings power after it has undergone a restructuring. In such cases, the company's past earnings may not serve as the best proxy for its future earnings, as capacity reductions shrink the company's ability to derive profits. Today, we apply this methodology to a company that fits this criteria.

LCA-Vision (LCAV) provides laser vision corrective surgeries at its LasikPlus locations. This elective surgery has a very cyclical demand structure that closely mimics consumer confidence indices. As such, demand for this surgery has dropped considerably in the last year, in keeping with its correlation to consumer confidence levels. As a result, LCAV has had to close several locations.

Seeing as how the company no longer has the same capacity to earn as it did last year, investors must recognize this or risk overpaying as a result of overestimating the company's profit potential. To estimate the company's current earnings capacity (for which the company's current earnings are not an adequate proxy, due to demand shocks and severance/impairment charges), we look at the company's historical return on its fixed assets. We use fixed assets instead of total assets, since items in total assets such as cash and prepaid expenses don't have much effect on earnings yet they have comprised a relatively large portion of this company's assets in the past.

Over the last business cycle, LCAV's annual operating earnings have averaged around 20% of its net fixed assets. Since the company has closed locations and reduced the number of services it offers, its net fixed assets have dropped from about $120 million to just $90 million. Applying the 20% returns suggests the company current operating earnings power is around $18 million.

Of course, this analysis serves only as an estimate and contains many assumptions. For one thing, it assumes business conditions in the next earnings cycle will mimic those of the last cycle. However, strong economic conditions may not return as fast as they did in the last cycle, and competitive pressures may increase. As such, the investor must make adjustments to this rudimentary estimate. Net fixed assets are also subject to accounting estimates and management judgments, both of which can distort the calculation. Furthermore, not all fixed assets earn returns, as companies utilize certain portions for corporate use.

However, this estimate does serve as a useful starting point in estimating a company's earnings power, which is an important step in determining the intrinsic value of a stock.

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